Earn 5%, 6%, 30% -- Guaranteed

• Report this Comment On August 24, 2010, at 11:43 PM, vidar712 wrote:

  When I bought my house in January, I had to decide what I was going to do with the $8000 tax credit. In order to decide whether I should invest it or use the money to take a big chunk out of my mortgage, I calculated how much money I would save by paying down the debt. Then I calculated how much rate of return I would need to earn the same amount in earnings.

  I was surprised by my results. With a 30 year mortgage around 5% loan-interest it would only take around 3% earning-interest to reach the same amount of net worth over thirty years. Since 3% *should* be relatively easy to reach in the stock market, I invested the money.

  I determined that the reason that the earning-interest rate was lower than the loan-interest rate was because earning-interest is compounding (The effect of the rate is more and more as time goes on.) while the loan-interest is reverse-compounding (The effect of the rate is less and less as time goes on).

  Time frame is an important variable. If the time frame is too short, the compounding effect will not have time to work for you. You would need to determine how long you plan on holding your debt to decide if you should invest it, or pay down that debt.

  A credit card with a high interest rate and a (hopefully) short holding period will be a better candidate for paying down debt than a mortgage, that has a low interest rate and long holding period.

• Report this Comment On August 25, 2010, at 1:20 PM, pondee619 wrote:

  Of course, if you save that $1,000.00 you have it in case of an emergency. If you pay that $1,000.00 extra on your mortgage, you don't have it anymore. Next month you still have to make your regular mortgage payment. 20+ years from now your mortgage is paid of early. Let's not forget the importance of the emergency fund. How many of us truly can say that it is fully funded?

• Report this Comment On August 26, 2010, at 9:29 AM, decbutt wrote:

  You also have to factor in Inflation. And no, they don't cancel each-other out.

  Price inflation erodes savings, but wage inflation erodes debt.

  Simple example: if you borrowed a cool Z$1m of a Zimbabwean bank in 2001 that was due for repayment in full in 2011, but you had no savings, would you worry? No.

  The debt has been eroded.

  Likewise with a long term mortgage debt, the erosion over a 25 year period is substantial (but on a much smaller scale of course).

  Think back to how much people were paying for property 20 years ago - £40k buy you something nice?

  Sure.

  One of the least understood phenomena in the media is how debt gets eaten away by inflation.

  In simple terms the more you put off doing your homework, the easier it gets.

  If we have a period of DEflation, that is a very different scenario - that makes your debt worse!

  But, if there was to be any deflation it would, most likely, be very short lived.

  I'd rather keep the $1000.

• Report this Comment On August 26, 2010, at 1:37 PM, Pepperika wrote:

  These comments were helpful to me. Even though the real estate market is terrible, I may want to sell my house in the near future. I have owned it 12 years and may not be able to get my purchase price for it. From what I have "heard" here, I am probably better off not trying to pay down the mortgage. At present I am regularly paying an additional $50.00 per month, so I think I will leave it at that.

• Report this Comment On August 29, 2010, at 9:42 AM, nprfreak wrote:

  A good brief on debt paydown returns from Selena (one of the "way back" names on TMF) prompting posts that expand on the idea. How and whether the paydown gets done is obviously an individual decision based on many factors.

  So far the comments only address the mortgage paydown question. I take it that's because of a tactic agreement that paydown of high interest revolving debt is a no-brainer use of discretionary income. I agree. For my own comment, I'm going to stick with mortgage and revolving credit card debt. There is another flavor, installment loans. These can be unsecure or secured such as by CDs or automobiles. I would tend to lump those in with the mortgage question because they are less detrimental on credit reports and because the required payment does not change following excess principal payments.

  I tend weigh the revolver vs. mortage decision in terms of percentage principal paydown and the future benefits. In general, I would assume that people holding both kinds of debt have dramatically lower balances in revolving debt. The next-month interest reduction when extra principal is applied to a smaller revolving loan might be in multiple of dollars while the mortgage interest reduction would be pennies, even if the revolving rate is at a lower rate.

  Extra toward revolving debt has another immediate benefit: every $1000 principal paydown on a card basing the minimum on 2% of balance reduces the next required payment by $20. This adds some cash flow flexibility for those holding debt on more than one card or self-employed. Essentially, discretionary income is immediately increased by $20.

  The future benefit of mortgage paydown is much harder to quantify, highly subjective and will only be realized when the house is sold or the mortgage paid off. However, I don't think it's an either/or decision. Equity building can be dramatically accelerated by even small additional principal payments early in a mortgage when substantially all of the payment goes toward interest. Even rounding the payment up to an even $5, $10, or $20 amount can turn your first year equity build into the equivalent of your 2nd or 3rd year. For someone with both kinds of debt and a stable employment situation, these small principal nibbles might be considered a good long term investment.

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